Module 3

Syllabus

Consumer surplus, Producer surplus, Market Efficiency: Welfare and Deadweight Loss;
Basic Applications – Taxation; Market Failures – Economics of information, public goods,
Externalities and Public Policy
What Is Consumer Surplus?
Consumer surplus is an economic measurement of consumer benefits resulting from market
competition. A consumer surplus happens when the price that consumers pay for a product
or service is less than the price they're willing to pay. It's a measure of the additional benefit
that consumers receive because they're paying less for something than what they were
willing to pay.
Consumer surplus may be compared with producer surplus.
 A consumer surplus happens when the price consumers pay for a product or service
is less than the price they're willing to pay.
 Consumer surplus is based on the economic theory of marginal utility, which is the
additional satisfaction a consumer gains from one more unit of a good or service.
 Consumer surplus always increases as the price of a good falls and decreases as the
price of a good rises.
 It is depicted visually by economists as the triangular area under the demand curve
between the market price and what consumers would be willing to pay.
 Consumer surplus plus producer surplus equals the total economic surplus.
Understanding Consumer Surplus
The concept of consumer surplus was developed in 1844 to measure the social benefits
of public goods such as national highways, canals, and bridges. It has been an important tool
in the field of welfare economics and the formulation of tax policies by governments.
Consumer surplus is based on the economic theory of marginal utility, which is the
additional satisfaction a consumer gains from one more unit of a good or service. The utility
a good or service provides varies from individual to individual based on their personal
preference.
Typically, the more of a good or service that consumers have, the less they're willing to
spend for more of it, due to the diminishing marginal utility or additional benefit they

1
receive. A consumer surplus occurs when the consumer is willing to pay more for a given
product than the current market price.

Many producers are influenced by consumer surplus when they set their prices.
The Formula for Consumer Surplus
Economists define consumer surplus with the following equation:
Consumer surplus = (½) x Qd x ΔP

where:
 Qd = the quantity at equilibrium where supply and demand are equal
 ΔP = Pmax – Pd, or the price at equilibrium where supply and demand are equal
 Pmax = the price a consumer is willing to pay
Measuring Consumer Surplus
The demand curve is a graphic representation used to calculate consumer surplus. It shows
the relationship between the price of a product and the quantity of the product demanded at
that price, with the price drawn on the y-axis of the graph and the quantity demanded drawn
on the x-axis. Because of the law of diminishing marginal utility, the demand curve is
downward sloping.
Consumer surplus is measured as the area below the downward-sloping demand curve, or
the amount a consumer is willing to spend for given quantities of a good, and above the
actual market price of the good, depicted with a horizontal line drawn between the y-axis
and demand curve. Consumer surplus can be calculated on either an individual or aggregate
basis, depending on if the demand curve is individual or aggregated.
Consumer surplus always increases as the price of a good falls and decreases as the price of
a good rises. For example, suppose consumers are willing to pay $50 for the first unit of
product A and $20 for the 50th unit. If 50 of the units are sold at $20 each, then 49 of the
units were sold at a consumer surplus, assuming the demand curve is constant.
Consumer surplus is zero when the demand for a good is perfectly elastic. But demand is
perfectly inelastic when consumer surplus is infinite.
Economic welfare is also called community surplus, or the total of consumer and producer
surplus.
Example of Consumer Surplus

2
Consumer surplus is the benefit or good feeling of getting a good deal. For example, let's say
that you bought an airline ticket for a flight to Disney World during school vacation week
for $100, but you were expecting and willing to pay $300 for one ticket. The $200 represents
your consumer surplus.
However, businesses know how to turn consumer surplus into producer surplus or for their
gain. In our example, let's say the airline realizes your surplus and as the calendar draws
near to school vacation week raises its ticket prices to $300 each.
The airline knows there will be a spike in demand for travel to Disney World during school
vacation week and that consumers will be willing to pay higher prices. So by raising the
ticket prices, the airlines are taking consumer surplus and turning it into producer surplus or
additional profits.
Is a High Consumer Surplus Good?
A high consumer surplus means that goods are priced quite a bit lower in the market than
where consumers would ultimately be willing to pay. This is often the result of a high degree
of competition, technological progress, and producer efficiency. In general, all of these
things are considered to be "good" for promoting economic growth and prosperity.
What Is Total Economic Surplus?
Total economic surplus is equal to the producer surplus plus the consumer surplus. It
describes the total net benefit to society from free markets in goods or services.
The Bottom Line
In free markets, producers compete with one another to be the low-cost producer and grab
market share from other companies in their space. The result is more quantity and lower
prices for consumers, often lower than where they would be willing to pay for it. This
difference between the market price (as determined by supply and demand) and the
willingness to pay is the consumer surplus. A consumer surplus is seen as a benefit to the
economy.
What Is a Producer Surplus?
Producer surplus is the difference between how much a person would be willing to accept
for a given quantity of a good versus how much they can receive by selling the good at the
market price. The difference or surplus amount is the benefit the producer receives for
selling the good in the market.

3
A producer surplus is generated by market prices in excess of the lowest price producers
would otherwise be willing to accept for their goods. This may relate to Walras' law.
KEY TAKEAWAYS
 Producer surplus is the total amount that a producer benefits from producing and
selling a quantity of a good at the market price.
 The total revenue that a producer receives from selling their goods minus the
marginal cost of production equals the producer surplus.
 Producer surplus plus consumer surplus represents the total economic benefit to
everyone in the market from participating in production and trade of the good.
Understanding Producer Surplus
A producer surplus is shown graphically below as the area above the producer's supply
curve that it receives at the price point (P(i)), forming a triangular area on the graph. The
producer’s sales revenue from selling Q(i) units of the good is represented as the area of the
rectangle formed by the axes and the red lines, and is equal to the product of Q(i) times the
price of each unit, P(i).
Because the supply curve represents the marginal cost of producing each unit of the good,
the producer’s total cost of producing Q(i) units of the good is the sum of the marginal cost
of each unit from 0 to Q(i) and is represented by the area of the triangle under the supply
curve from 0 to Q(i).
Subtracting the producer’s total cost (the triangle under the supply curve) from his total
revenue (the rectangle) shows the producer’s total benefit (or producer surplus) as the area
of the triangle between P(i) and the supply curve.
The Formula for Producer Surplus Is:
Total revenue - marginal cost = producer surplus

The size of the producer surplus and its triangular depiction on the graph increases as
the market price for the good increases, and decreases as the market price for the good
decreases.
Special Considerations
Producers would not sell products if they could not get at least the marginal cost to produce
those products. The supply curve as depicted in the graph above represents the marginal cost
curve for the producer.

4
From an economics standpoint, marginal cost includes opportunity cost. In essence, an
opportunity cost is a cost of not doing something different, such as producing a separate
item. The producer surplus is the difference between the price received for a product and the
marginal cost to produce it.
Because marginal cost is low for the first units of the good produced, the producer gains the
most from producing these units to sell at the market price. Each additional unit costs more
to produce because more and more resources must be withdrawn from alternative uses, so
the marginal cost increases and the net producer surplus for each additional unit is lower and
lower.
Producer Surplus vs. Profit
Profit is a closely-related concept to producer surplus; however, they differ
slightly. Economic profit takes revenues and subtracts both fixed and variable costs.
Producer surplus, on the other hand, only takes off variable (marginal) costs.
Consumer Surplus and Producer Surplus
A producer surplus combined with a consumer surplus equals overall economic surplus or
the benefit provided by producers and consumers interacting in a free market as opposed to
one with price controls or quotas. If a producer could price discriminate correctly, or charge
every consumer the maximum price the consumer is willing to pay, then the producer could
capture the entire economic surplus. In other words, producer surplus would equal overall
economic surplus.
However, the existence of producer surplus does not mean there is an absence of a consumer
surplus. The idea behind a free market that sets a price for a good is that both consumers and
producers can benefit, with consumer surplus and producer surplus generating greater
overall economic welfare. Market prices can change materially due to consumers, producers,
a combination of the two, or other outside forces. As a result, profits and producer surplus
may change materially due to market prices.
Producer Surplus Example
Say that there are 20 companies that make widgets, each producing them at slightly different
costs. ranging from $2.50 to $3.50 per widget. In the market, there is an equilibrium point
where the amount of widgets supplied meets demand at $3.00.
The producer surplus would define those producers who can make widgets for less than
$3.00 (down to $2.50), while those whose costs are up to $3.50 will experience a loss
instead. For the lowest-cost producer, they would enjoy a surplus of $0.50 per widget.

5
How Do You Measure Producer Surplus?
With supply and demand graphs used by economists, the producer surplus would be equal to
the triangular area formed above the supply line over to the market price. It can be
calculated as the total revenue less the marginal cost of production.
What Is Producer Surplus Simply Put?
Put simply, the producer surplus is the difference between the price that companies are
willing to sell products for and the prices that they actually get for them.
What Is Total Surplus?
Total economic surplus is equal to the producer surplus plus the consumer surplus.
What Is Market Efficiency?
Market efficiency refers to the degree to which market prices reflect all available, relevant
information. If markets are efficient, then all information is already incorporated into prices,
and so there is no way to "beat" the market because there are no undervalued or overvalued
securities available.
The term was taken from a paper written in 1970 by economist Eugene Fama, however Fama
himself acknowledges that the term is a bit misleading because no one has a clear definition
of how to perfectly define or precisely measure this thing called market efficiency. Despite
such limitations, the term is used in referring to what Fama is best known for, the efficient
market hypothesis (EMH).
The EMH states that an investor can't outperform the market, and that market anomalies
should not exist because they will immediately be arbitraged away. Fama later won the Nobel
Prize for his efforts. Investors who agree with this theory tend to buy index funds that track
overall market performance and are proponents of passive portfolio management.2
KEY TAKEAWAYS
 Market efficiency refers to how well current prices reflect all available, relevant
information about the actual value of the underlying assets.
 A truly efficient market eliminates the possibility of beating the market, because any
information available to any trader is already incorporated into the market price.
 As the quality and amount of information increases, the market becomes more
efficient reducing opportunities for arbitrage and above market returns.
At its core, market efficiency is the ability of markets to incorporate information that
provides the maximum amount of opportunities to purchasers and sellers of securities to

6
effect transactions without increasing transaction costs. Whether or not markets such as the
U.S. stock market are efficient, or to what degree, is a heated topic of debate among
academics and practitioners.
Market Efficiency Explained
There are three degrees of market efficiency. The weak form of market efficiency is that past
price movements are not useful for predicting future prices. If all available, relevant
information is incorporated into current prices, then any information relevant information that
can be gleaned from past prices is already incorporated into current prices. Therefore future
price changes can only be the result of new information becoming available.3
Based on this form of the hypothesis, such investing strategies such as momentum or any
technical-analysis based rules used for trading or investing decisions should not be expected
to persistently achieve above normal market returns. Within this form of the hypothesis there
remains the possibility that excess returns might be possible using fundamental analysis. This
point of view has been widely taught in academic finance studies for decades, though this
point of view is no long held so dogmatically.
The semi-strong form of market efficiency assumes that stocks adjust quickly to absorb new
public information so that an investor cannot benefit over and above the market by trading on
that new information. This implies that neither technical analysis nor fundamental analysis
would be reliable strategies to achieve superior returns, because any information gained
through fundamental analysis will already be available and thus already incorporated into
current prices. Only private information unavailable to the market at large will be useful to
gain an advantage in trading, and only to those who possess the information before the rest of
the market does.
The strong form of market efficiency says that market prices reflect all information both
public and private, building on and incorporating the weak form and the semi-strong form.
Given the assumption that stock prices reflect all information (public as well as private), no
investor, including a corporate insider, would be able to profit above the average investor
even if he were privy to new insider information.5
Differing Beliefs of an Efficient Market
Investors and academics have a wide range of viewpoints on the actual efficiency of the
market, as reflected in the strong, semi-strong, and weak versions of the EMH. Believers in
strong form efficiency agree with Fama and often consist of passive index investors.

7
Practitioners of the weak version of the EMH believe active trading can generate abnormal
profits through arbitrage, while semi-strong believers fall somewhere in the middle.6
For example, at the other end of the spectrum from Fama and his followers are the value
investors, who believe stocks can become undervalued, or priced below what they are worth.
Successful value investors make their money by purchasing stocks when they
are undervalued and selling them when their price rises to meet or exceed their intrinsic
worth.
People who do not believe in an efficient market point to the fact that active traders exist. If
there are no opportunities to earn profits that beat the market, then there should be no
incentive to become an active trader. Further, the fees charged by active managers are seen as
proof the EMH is not correct because it stipulates that an efficient market has low transaction
costs.
An Example of an Efficient Market
While there are investors who believe in both sides of the EMH, there is real-world proof that
wider dissemination of financial information affects securities prices and makes a market
more efficient.
For example, the passing of the Sarbanes-Oxley Act of 2002, which required greater financial
transparency for publicly traded companies, saw a decline in equity market volatility after a
company released a quarterly report. It was found that financial statements were deemed to
be more credible, thus making the information more reliable and generating more confidence
in the stated price of a security. There are fewer surprises, so the reactions to earnings reports
are smaller. This change in volatility pattern shows that the passing of the Sarbanes-Oxley
Act and its information requirements made the market more efficient. This can be considered
a confirmation of the EMH in that increasing the quality and reliability of financial
statements is a way of lowering transaction costs.7
Other examples of efficiency arise when perceived market anomalies become widely known
and then subsequently disappear. For instance, it was once the case that when a stock was
added to an index such as the S&P 500 for the first time, there would be a large boost to that
share's price simply because it became part of the index and not because of any new change
in the company's fundamentals. This index effect anomaly became widely reported and
known, and has since largely disappeared as a result. This means that as information
increases, markets become more efficient and anomalies are reduced.
Market Efficiency

8
Two concepts of efficiency are used to judge market performance. The first, called
productive efficiency, refers to producing output at the least possible cost. The second,
called the allocative efficiency, refers to producing the output that consumers value the
most. Perfect competition guarantees both productive efficiency and allocative efficiency in
the long run.
Productive efficiency
Productive efficiency occurs when each firm produces at the minimum point on its long run
average cost curve, so the market price equals the minimum average cost. The entry and exit
of firms and any adjustment in the scale of each firm ensure that each firm produces at the
minimum of its long run average cost curve. Firms that do not reach minimum long run
average cost must, to avoid continued losses, either adjust their scale or leave the industry.
Thus, perfect competition produces output at minimum average cost in the long run.
Allocative efficiency
Just because production occurs at the least possible cost does not mean that the allocation of
resources is the most efficient one possible. The products many not be the ones consumers
want. This situation is akin to that of the airline pilot who informs passengers that there’s
good news and bad news: “The good news is that we’re making record time. The bad news
is that we’re lost!” Likewise, firms may be producing goods efficiently but producing the
wrong goods – that is, making stuff right but making the wrong stuff.
Allocative efficiency occurs when each firm produces the output that consumers value most.
How do we know that perfect competition guarantees allocative efficiency? The answer lies
with the market demand and supply curves. Recall that the demand curve reflects the
marginal value that consumers attach to each unit of the good, so the market price is the
amount people are willing and able to pay for the final unit they consume. We also know
that, in both the short run and the long run, the equilibrium price in perfect competition
equals the marginal cost of supplying the last unit sold. Marginal cost measures the
opportunity cost of resources employed to produce that last unit sold. Thus, the demand and
supply curves intersect at the combination of price and quantity at which the marginal value,
or the marginal benefit that consumers attach to the final unit purchased, just equals the
opportunity cost of the resources employed to produce that unit.
As long as marginal benefit equals marginal cost, the last unit produced is valued by
consumers as much as, or more than, any other good those resources could have produced.
There is no way to reallocate resources to increase the total value of all output in the
economy. Thus, there is no way to reallocate resources to increase the total utility or total

9
benefit consumers reap from production. When the marginal benefit that consumers derive
from a good equals the marginal cost of producing that good, that market is said to be
allocatively efficient.
Marginal benefit = Marginal cost
Firms not only are making stuff right, but they are also making the right stuff.
Social welfare
If the marginal cost of supplying a good just equals the marginal benefit to consumers, does
this mean that market exchange confers no net benefits to participants? No. Market
exchange usually benefits both consumers and producers. Recall that consumers enjoy a
surplus from market exchange because the most they would be willing and able to pay for
each unit of the good usually exceeds what they actually do pay. The below exhibit depicts a
market in the short-run equilibrium. The consumer surplus in this exhibit is represented
between $10 and D curve which is the area below the demand curve but above the market
clearing price of $10.

Consumer surplus
E S
Dollars per unit $10
Producer surplus
6 D
5 m

0 1,00, 000 1,20,000 2,00, 000 Quantity per period

Producers in the short run also usually derive a net benefit, or a surplus, from market
exchange, because the price they receive exceeds the least they would accept to supply that
quantity in the short run. Recall that the short run market supply curve is the sum of each
firm’s marginal cost curve at and above its minimum average variable cost. Point m in the
exhibit is the minimum point on the market supply curve, indicating that at a price of $5,
quantity supplied would be zero because firms could not cover average variable cost. A
price of $5 just covers average variable cost.

10
If the market price rises to $6, quantity supplied increases until marginal cost equals $6.
Market output increases from 1, 00, 000 to 1, 20, 000 units. Total revenue in this market
increases from $5, 00, 000 to $7, 20, 000. Part of the higher revenue covers the higher
marginal cost of production. But the rest provides a bonus to producers. After all, suppliers
would have offered the first 1,00,000 units for only $5 each. If the price is $6, firms get to
supply these 1,00,000 units for $6 each. Producer surplus is between the prices of $5 and $6.
In the short-run producer surplus equals the total revenue producers are paid minus their
variable cost of production. In the exhibit the market clearing price is $10 per unit and
producer surplus is depicted between a price of $5 and the market price of $10. If the market
price is less than $5, and the market shut down, so they garner no producer surplus. Any
price that exceeds average variable cost, which is $5 in this example, generates a producer
surplus. A high enough price could yield economic profit.

The combination of consumer surplus and producer surplus shows the gains from voluntary
exchange. Productive and allocative efficiency in the short run occurs at equilibrium point e,
which also is the combination of price and quantity that maximises the sum of consumer
surplus and producer surplus, thus maximising social welfare.

Social welfare is the overall well-being of people in the economy. Even though marginal
cost equals marginal benefit for the final unit produced and consumed, both producers and
consumers usually derive a surplus, or a bonus, from market exchange. Voluntary exchange
typically makes both sides of the market better off (win-win). And competition usually
improves product quality as well. For example, one study found that the entry of one more
hospital to a local market increased the heart attack survival rate by about 10%.
Understanding Deadweight Loss
A deadweight loss occurs when supply and demand are not in equilibrium, which leads to
market inefficiency. Market inefficiency occurs when goods within the market are either
overvalued or undervalued. While certain members of society may benefit from the
imbalance, others will be negatively impacted by a shift from equilibrium.
The market can regain stable footing when demand and supply fall into better alignment
through interventions or consumer actions.

11
When consumers do not feel the price of a good or service is justified when compared to the
perceived utility, they are less likely to purchase the item.

For example, overvalued prices may lead to higher profit margins for a company, but it
negatively affects consumers of the product. For inelastic goods—meaning demand does not
change for that particular good or service when the price goes up or down—the increased
cost may prevent consumers from making purchases in other market sectors. In addition,
some consumers may purchase a lower quantity of the item when possible.
For elastic goods—meaning sellers and buyers quickly adjust their demand for that good or
service if the price changes—consumers may reduce spending in that market sector to
compensate or be priced out of the market entirely.
Undervalued products may be desirable for consumers but may prevent a producer from
recuperating their production costs. If the product remains undervalued for a substantial
period, producers will either choose to no longer sell that product, up the price to
equilibrium, or may be forced out of the market entirely.
The Case of Land, Properties, and Rent
Land has a near-static supply; therefore, the margin between natural monopoly pricing and
rent caps creating deadweight loss is minimal or often non-existent in well-developed
property markets. In the case of rent, consumers bear most of the deadweight loss from
natural monopolies. In cities introducing rent caps, and a goal for economists is to calculate
caps that aren't set too low and lead to minimum consumer-producer losses so producers
are still willing to invest.
How Deadweight Loss Is Created
Minimum wage and living wage laws can create a deadweight loss by causing employers to
overpay for employees and preventing low-skilled workers from securing jobs. Price
ceilings and rent controls can also create deadweight loss by discouraging production and
decreasing the supply of goods, services, or housing below what consumers truly demand.
Consumers experience shortages and producers earn less than they would otherwise.
Taxes also create a deadweight loss because they prevent people from engaging in purchases
they would otherwise make because the final price of the product is above the equilibrium
market price. If taxes on an item rise, the burden is often split between the producer and the
consumer, leading to the producer receiving less profit from the item and the customer
paying a higher price. This results in lower consumption of the item than previously, which

12
reduces the overall benefits the consumer market could have received while simultaneously
reducing the benefit the company may see in regard to profits.
Monopolies and oligopolies also lead to deadweight loss as they remove the aspects of a
perfect market, in which fair competition accurately sets a price. Monopolies and oligopolies
can control supply for a specific good or service, thereby falsely increasing its price. This
would eventually lead to a lower amount of goods and services sold.
Example of Deadweight Loss
A new sandwich shop opens in your neighbourhood, selling a sandwich for $10. You
perceive the value of this sandwich to be $12 and, therefore, are happy to pay $10 for it.
Now, assume the government imposes a new sales tax on food items, which raises the cost
of the sandwich to $15. At $15, you feel that the sandwich is overvalued and believe that the
new cost is not a fair price and, therefore, are not willing to buy the sandwich at $15.
Many consumers, but not all, feel this way about the sandwich, and the sandwich shop sees a
decrease in demand for its sandwich and a decline in revenues. The deadweight loss in this
example is the unsold sandwiches as a result of the new $15 cost. If the decrease in demand
is severe enough, the sandwich shop could go out of business, further increasing the
negative economic effects of the new tax on society at large.
Basic applications – taxation
Modern governments undertake a variety of functions to accelerate economic growth and
promote social welfare. In order to incur expenditure, revenue has to be mobilised. There are
various sources of revenue to the government. The major ones are:
a. Tax revenue
This is one of the main sources of public revenue. Tax is defined as a compulsory payment
made by the people of a country to the government to meet public expenditure without any
direct quid pro quo. This implies that payment of tax is compulsory and it is collected by the
government to incur expenditure for the benefit of all. Moreover for payment of tax no
individual can demand a proportionate benefit from the government. The tax proceeds are
used by the government for common benefit rather than individual benefit. Various taxes are
levied by the government. They are classified as direct and indirect taxes. Direct taxes are
those taxes which are paid by the person on whom it is levied. The burden cannot be shifted,
for example income tax. Indirect taxes are those in which burden can be shifted, for
example, excise duty.
Direct and Indirect taxes

13
A direct tax is one in which the burden cannot be shifted. It is paid by the person on whom it
is levied. The impact and incidence are on the same person. In other words, the tax payer
and the tax bearer are one and the same. Examples of direct tax are income tax, wealth tax,
corporate tax, gift tax and capital gains tax. Indirect taxes are those in which the burden can
be shifted. The impact and incidence are on different persons and tax payer and tax bearer
are different. Examples of indirect taxes are Goods and Services Tax (GST), customs duty,
etc. Indirect taxes are also called as commodity taxes. Indirect taxes my be specific duties or
advalorem duties or a combination of both. If the tax is levied on the basis of per unit it is
called specific tax. If the commodity is taxed according to its value, then it is called
advalorem tax. For example if a tax of Rs. 5 is imposed on per unit of commodity X, then it
is termed as specific tax. On the other hand if a 5% tax is levied on the value of the
commodity then it is called advalorem tax.
Impact and Incidence of taxation
When taxes are levied by the governments, three concepts are studied to identify whether the
tax burden is shifted or borne by the person on whom it is levied. They are:
a. Impact of a tax: It refers to the initial burden of a tax. It is on the person on whom it is
legally levied by the government.
b. Incidence: It refers to the final burden of a tax. It cannot be shifted further. It is the
ultimate resting place of a tax.
For example, when commodity taxes are levied, the impact i.e., initial burden is on the
producers. The producers eventually shift the burden to the consumers. Hence the incidence
is on the consumers. In the case of direct taxes like income tax, the burden cannot be shifted.
Both impact and incidence are on the same person.
c. Shifting: It refers to the process of shifting the burden of a tax. Burden can be shifted
through sale and purchase. Price is the vehicle through which shifting takes place. There are
two types of shifting, namely i. Forward shifting and b. Backward shifting.
i. Forward shifting: When taxes are levied on producers of goods, they shift it to the
consumers either partly or fully to the consumers by including the tax amount in the price of
the commodity. This is referred to as forward shifting.
ii. Backward shifting: In this case the burden of the tax is shifted to the factors of
production or suppliers of raw materials, intermediary products by paying them less for their
supply. In the case of factors of production like labour they will offer less wages. In

14
backward shifting, price of the commodity will not change and the final consumers will not
have any burden of tax.
Forward and backward shifting may be combined by the producers at times. A part of the
burden will be shifted to the consumers and the other part of the burden will be shifted to the
factors of production in a combination of the two. Sometimes there can be a single point
shifting i.e. from the producer to the consumer directly. Shifting can also be a multiple one
when it involves many layers like producer to wholesaler to retailer and then finally to the
consumer.
Market failures
Market failure refers to the inefficient distribution of goods and services in the free market. In
a typical free market, the prices of goods and services are determined by the forces of supply
and demand, and any change in one of the forces results in a price change and a
corresponding change in the other force. The changes lead to price equilibrium.
Market failure occurs when there is a state of disequilibrium in the market due to market
distortion. It takes place when the quantity of goods or services supplied is not equal to the
quantity of goods or services demanded. Some of the distortions that may affect the free
market may include monopoly power, price limits, minimum wage requirements,
and government regulations.
Causes of Market Failures
Market failure may occur in the market for several reasons, including:

1. Externality
An externality refers to a cost or benefit resulting from a transaction that affects a third party
that did not decide to be associated with the benefit or cost. It can be positive or negative. A
positive externality provides a positive effect on the third party. For example, providing good
public education mainly benefits the students, but the benefits of this public good will spill
over to the whole society.
On the other hand, a negative externality is a negative effect resulting from the consumption
of a product, and that results in a negative impact on a third party. For example, even though
cigarette smoking is primarily harmful to a smoker, it also causes a negative health impact on
people around the smoker.

15
2. Public goods
Public goods are goods that are consumed by a large number of the population, and their cost
does not increase with the increase in the number of consumers. Public goods are both non-
rivalrous as well as non-excludable. Non-rivalrous consumption means that the goods are
allocated efficiently to the whole population if provided at zero cost, while non-excludable
consumption means that the public goods cannot exclude non-payers from its consumption.
Public goods create market failures if a section of the population that consumes the goods
fails to pay but continues using the good as actual payers. For example, police service is a
public good that every citizen is entitled to enjoy, regardless of whether or not they pay taxes
to the government.

3. Market control
Market control occurs when either the buyer or the seller possesses the power to determine
the price of goods or services in a market. The power prevents the natural forces of demand
and supply from setting the prices of goods in the market.
On the supply side, the sellers may control the prices of goods and services if there are only a
few large sellers (oligopoly) or a single large seller (monopoly). The sellers may collude to
set higher prices to maximize their returns. The sellers may also control the quantity of goods
produced in the market and may collude to create scarcity and increase the prices of
commodities.
On the demand side, the buyers possess the power to control the prices of goods if the market
only comprises a single large buyer (monopsony) or a few large buyers (oligopsony). If there
is only a single or a handful of large buyers, the buyers may exercise their dominance by
colluding to set the price at which they are willing to buy the products from the producers.
The practice prevents the market from equating the supply of goods and services to their
demand.

4. Imperfect information in the market

16
On the other hand, inadequate information on the seller’s side may mean that they may be
willing to accept a higher or lower price for the product than the actual opportunity cost of
producing it.
Solutions to Market Failures
In order to eliminate market failures, several remedies can be implemented. They include:

1. Use of legislation
One of the ways that governments can manage market failures is by implementing legislation
that changes behavior. For example, the government can ban cars from operating in city
centers, or impose high penalties to businesses that sell alcohol to underage children, since
the measures control unwanted behaviors.

2. Price mechanism
Price mechanisms are designed to change the behavior of both the consumers and producers.
For products that cause harm to consumers, the government can discourage their
consumption by increasing taxes. For example, taxes on cigarettes and alcohol are
periodically increased to discourage their consumption and reduce their harmful effects on
unrelated third parties.
Economics of Information has always been a valuable asset to those who possess it. Where
the fish were biting was an important piece of information to tribal societies. They shared this
information because it was in the interests of the community to do so, and the catch was
shared by all members of the tribe. Today where the fish are biting is a carefully guarded
secret by fishermen who store the longitude and latitude in the memories of their Loran
equipment on their fishing boats. Their boats are also equipped with satellite antenna in order
to obtain access to the remote sensing satellite data that discloses where the schools of fish
are concentrating and what prices are offered for their catch on the global markets.
The U.S. economy has been in a state of transition from an agricultural economy in the 19th
century to an information economy in the 21st century. In 1790 we were largely an economy
of farmers. Today we are predominantly an economy of information workers. According to
U.S. Commerce Secretary Ron Brown, about 60% of our work force today is engaged in
activities that are producing information products.
The United States has passed all too briefly, it seems, through an industrial economy that was
the envy of the world. The agrarian economy was one in which information was most often
cherished as a public resource that should be shared in order to enhance the collective

17
performance of all agricultural components. These were highly disaggregated and could not
be expected to fund their own research. An information society is also disaggregated, but one
in which the primary foundation of the economy may become collecting, processing,
distributing and archiving information as a primary source of income upon which the society
must rely for its economic health. We are at that crossroads now.
Thus we have a thriving information industry that has been growing at some 20-25% per year
for the past several decades. However, as we see the burgeoning growth and use of new
information technologies, we also see an erosion of the traditional public institutions that
support information processing and distribution.
An information economy is based upon the premise that information has economic value and
requires an information marketplace in which such value can be exchanged. However, this
economic reality runs counter to the popular historic notion that information is free.
Confusion about What We Mean
In discussing the information is free notion, we often create immediate confusion. First, we
apply the terms public and private to information, but without clarification of their meanings.
We may mean that the information itself is from public or private funding sources, e.g., tax-
funded or from foundation grants or purchase orders. Or, we may refer to the physical spaces
in which information is found, i.e., either a private place for which our entry requires
permission, or a public space in which everyone is invited, such as a public library. Or, we
may wish to suggest the uses to which information is put or the means by which it is
distributed, e.g., a memorandum to a private group or public dissemination on television.
Finally, we may mean what the economists mean when they differentiate between public and
private goods.
Whatever we mean, economic costs are associated with discovering, gathering, processing,
manipulating, archiving and even using information. We invest time, which is a constant and
not variable. As much as I admire the volunteers of Project Gutenberg, who are busily
rendering into machine-readable form all of the great works of literature, their efforts are not
free. They are spending, and I use the term advisedly, their time and skills to assemble this
gift that they are putting into the global information commons.
We also spend money on the resources we need to gather, process and distribute information.
Most expensive of all, we deploy humans in the form of professionals skilled in producing
computer software, designing search algorithms and developing more user-friendly interfaces
to the world's cornucopia of knowledge.

18
Intellectual property is financed in basically three ways: by patronage, procurement and
property. Patronage refers to the funding of information producers, processors or archivists
within fully funded and budgeted institutions such as the Library of Congress, the U.S.
Geological Survey or ARPA.
Procurement means the contracting out of information products by institutional mandate, as,
for example, the purchase of product from independent contractors who provide the
information services and deliver the completed product for a stated price. This methodology
is used widely in economically advanced economies and intergovernmental institutions such
as the Organization for Economic Cooperation and Development (OECD) and the World
Bank. Such independent contractors, often telecommuting workers, are a fast-growing
segment of the information economy in the private as well as the public sector.
Financing intellectual property by property rights means the undertaking of information
gathering and processing by independent entrepreneurs who anticipate that they will be able
to obtain compensation for their labor on an open market when their product is made
available to the consuming public. Human capital must be provided with a reasonable
expectation of a return on the investment of intellectual skills as well as the use of the
information processing machines that support productivity. The marketplace of information
depends upon informatics professionals whose financial health depends on their ability to
attract customers willing to pay either from public or private coffers for their labors.
But this form of funding, unlike patronage and procurement which provide a source of
income for the writer, video artist or information providers, requires legal protection of
intellectual property rights for effective performance in the electronic marketplace. And as
yet, we have not managed to translate our legal system for the protection of information
property into a viable system for the information age.
Public goods
In economics, a public good refers to a commodity or service that is made available to all
members of society. Typically, these services are administered by governments and paid for
collectively through taxation.
Examples of public goods include law enforcement, national defense, and the rule of law.
Public goods also refer to more basic goods, such as access to clean air and drinking water.
KEY TAKEAWAYS
 Public goods are commodities or services that benefit all members of society, and
which are often provided for free through public taxation.

19
  Public goods are the opposite of private goods, which are inherently scarce and are
paid for separately by individuals.
 Societies will disagree about which goods should be considered public goods; these
differences are often reflected in nations’ government spending priorities.
How Public Goods Work
The two main criteria that distinguish a public good are that it must be non-rivalrous and
non-excludable. Non-rivalrous means that the goods do not dwindle in supply as more
people consume them; non-excludability means that the good is available to all citizens.
An important issue that is related to public goods is referred to as the free-rider problem.
Since public goods are made available to all people–regardless of whether each person
individually pays for them–it is possible for some members of society to use the good
despite refusing to pay for it. People who do not pay taxes, for example, are essentially
taking a "free ride" on revenues provided by those who do pay them, as do turnstile jumpers
on a subway system.
National defense, law enforcement, and clean air and water are all examples of public
goods.
Private Goods vs. Public Goods
The opposite of a public good is a private good, which is both excludable and rivalrous.
These goods can only be used by one person at a time—for example, a wedding ring. In
some cases, they may even be destroyed in the act of using them, such as when a slice of
pizza is eaten. Private goods generally cost money, and this amount pays for their private
use. Most of the goods and services that we consume or make use of in our everyday lives
are private goods. Although they are not subject to the free-rider problem, they are also not
available to everyone, since not everyone can afford to purchase them.
In some cases, public goods are not fully non-rivalrous and non-excludable. For example,
the post office can be seen as a public good, since it is used by a large portion of the
population and is financed by taxpayers. However, unlike the air we breathe, using the post
office does require some nominal costs, such as paying for postage. Similarly, some goods
are described as “quasi-public” goods because, although they are made available to all, their
value can diminish as more people use them. For example, a country’s road system may be
available to all its citizens, but the value of those roads declines when they become
congested during rush hour.
Public Goods in Different Countries

20
Individual countries will reach different decisions as to which goods and services should be
considered public goods, and this is often reflected in their national budgets. For example,
many argue that national defense is an important public good because the security of the
nation benefits all of its citizens. To that end, many countries invest heavily in their
militaries, financing army upkeep, weapons purchases, and research and
development (R&D) through public taxation. In the United States, for example, the
Department of Defense (DOD) has a budget of $2 trillion, equal to 16% of the total federal
budget for FY 2023.1
Some countries also treat social services–such as healthcare and public education–as a type
of public good. For example, some countries, including Canada, Mexico, the United
Kingdom, France, Germany, Italy, Israel, and China, provide taxpayer-funded healthcare to
their citizens.2 Similarly, government investments in public education have grown
tremendously in recent decades. According to estimates by Our World in Data, world
literacy has grown from roughly 56% to over 86% between 1950 and 2016 (the most
recently available data).3
Advocates for this kind of government spending on public goods argue that its economic and
social benefits significantly outweigh its costs, pointing to outcomes such as improved
workforce participation, higher-skilled domestic industries, and reduced rates of poverty
over the medium to long-term. Critics of this kind of spending argue that it can pose a
burden on taxpayers and that the goods in question can be more efficiently provided through
the private sector.
What Counts As a Public Good?
A public good may vary based on the country but generally includes services such as
national defense or the police and basic essentials, such as clean air and drinking water.
What Are the Main Differences between Private and Public Goods?
A private good is only used by one person at a time and often has a cost associated with it
that could make it prohibitive for some people.
What Is a Quasi-Public Good?
Quasi-public goods have elements of both public and private goods, such as a public bridge
that is available to all but loses value when it becomes congested during rush hour.
The Bottom Line

21
Public goods are commodities or services that are available to all members of society.
Because projects require a portion of the entire budget, policymakers must determine if the
benefits of one project will outweigh the benefits of spending on another project. These are
goods that do not become more scarce when people use them. National defense, effective
policing, clean air, and public education are all examples of public goods. Private goods,
unlike public goods, are goods that are inherently scarce and become more scarce when
people consume them.
What Is an Externality?
An externality is a cost or benefit caused by a producer that is not financially incurred or
received by that producer. An externality can be both positive or negative and can stem from
either the production or consumption of a good or service. The costs and benefits can be
both private—to an individual or an organization—or social, meaning it can affect society as
a whole.
KEY TAKEAWAYS
 An externality is an event that occurs as a byproduct of another event occurring.
 An externality can be good or bad, often noted as a positive externality or negative
externality.
 An externality can also be generated when something is made (i.e. a production
externality) or used (i.e. a consumption externality).
 Pollution caused by commuting to work or a chemical spill caused by improperly
stored waste are examples of externalities.
 Governments and companies can rectify externalities by financial and social
measures.
Understanding Externalities
Externalities occur in an economy when the production or consumption of a specific good or
service impacts a third party that is not directly related to the production or consumption of
that good or service.
Almost all externalities are considered to be technical externalities. Technical externalities
have an impact on the consumption and production opportunities of unrelated third parties,
but the price of consumption does not include the externalities. This exclusion creates a gap
between the gain or loss of private individuals and the aggregate gain or loss of society as a
whole.

22
The action of an individual or organization often results in positive private gains but detracts
from the overall economy. Many economists consider technical externalities to be market
deficiencies, and this is the reason people advocate for government intervention to curb
negative externalities through taxation and regulation.
Externalities were once the responsibility of local governments and those affected by them.
So, for instance, municipalities were responsible for paying for the effects of pollution from
a factory in the area while the residents were responsible for their healthcare costs as a result
of the pollution. After the late 1990s, governments enacted legislation imposing the cost of
externalities on the producer.
Many corporations pass the cost of externalities on to the consumer by making their goods
and services more expensive.
Types of Externalities
Externalities can be broken into two different categories. First, externalities can be measured
as good or bad as the side effects may enhance or be detrimental to an external party. These
are referred to as positive or negative externalities. Second, externalities can be defined by
how they are created. Most often, these are defined as a production or consumption
externality.
Negative Externalities
Most externalities are negative. Pollution is a well-known negative externality. A
corporation may decide to cut costs and increase profits by implementing new operations
that are more harmful to the environment. The corporation realizes costs in the form of
expanding operations but also generates returns that are higher than the costs.
However, the externality also increases the aggregate cost to the economy and society
making it a negative externality. Externalities are negative when the social costs outweigh
the private costs.
Positive Externalities
Some externalities are positive. Positive externalities occur when there is a positive gain on
both the private level and social level. Research and development (R&D) conducted by a
company can be a positive externality. R&D increases the private profits of a company but
also has the added benefit of increasing the general level of knowledge within a society.
Similarly, the emphasis on education is also a positive externality. Investment in education
leads to a smarter and more intelligent workforce. Companies benefit from hiring employees

23
who are educated because they are knowledgeable. This benefits employers because a better-
educated workforce requires less investment in employee training and development costs.
Production Externalities
A production externality is an instance where an industrial operation has a side effect. This
is often the type of externality used as example, as it is easy to envision an environmental
catastrophe caused by improperly stored chemicals by a chemical company. Because of how
the company produced its goods or protected its waste, an externality occurred.
Consumption Externalities
Externalities may also occur based on when or how a consumer base utilizes resources.
Consider the example of how you get to work. Those who choose to drive are creating a
pollution externality by driving their own car. Those who choose to take public transit or
walk are not causing the same externality. Instead of a side effect occurring because
something is being produced, an externality is caused because of an item being consumed.
These four types of externalities above are often combined to define a single externality. For
example, an externality may be a positive production, negative production, positive
consumption, or negative consumption externality.

Externality Solutions
There are solutions that exist to overcome the negative effects of externalities. These can
include those from both the public and private sectors.
Taxes
Taxes are one solution to overcoming externalities. To help reduce the negative effects of
certain externalities such as pollution, governments can impose a tax on the goods causing
the externalities. The tax, called a Pigovian tax—named after economist Arthur C. Pigou—is
considered to be equal to the value of the negative externality.
This tax is meant to discourage activities that impose a net cost to an unrelated third party.
That means that the imposition of this type of tax will reduce the market outcome of the
externality to an amount that is considered efficient.
Subsidies
Subsidies can also overcome negative externalities by encouraging the consumption of a
positive externality. One example would be to subsidize orchards that plant fruit trees to
provide positive externalities to beekeepers.

24
This nudge has the potential to influence behavioral economics, as additional incentives one
way or another way dictate the choices that are made. The subsidy is often placed on an
opposing item to detract from a specific activity as well. For example, government
incentives to upgrade to more energy-efficient renovations subtly discourages consumers
against options with more externalities.
Other Government Regulation
Governments can also implement regulations to offset the effects of externalities. Regulation
is considered the most common solution. The public often turns to governments to pass and
enact legislation and regulation to curb the negative effects of externalities. Several
examples include environmental regulations or health-related legislation.
The primary issue with government regulation of externalities is the need for consistent and
reliable information to track the externality is being managed or overcome. Consider
regulation against pollution. The government put forth resources to ensure that the
legislation put in place is actually being followed, including holding bad actors accountable
for not properly addressing their externality.
Real-World Examples of Externalities
Many countries around the world enact carbon credits that may be purchased to offset
emissions. These carbon credit prices are market-based that may often fluctuate in cost
depending on the demand of these credits to other market participants.
One program within the United States is the Regional Greenhouse Gas Initiative (RGGI).
The RGGI is made up of 12 states: California and 11 Northeast states. RGGI is a mandatory
cap-and-trade program that limits carbon dioxide emissions from the power sector.1
Different agencies are imposed a cap on externalities, though they can trade resources to
change what their cap is. Agencies that struggle managing their externality (i.e. pollution)
may need to purchase additional credits to have their cap increased. Other agencies that
conquer their externality may sell part of their cap space to recover capital likely used to
overcome their externalities.
How Do Externalities Affect the Economy?
Externalities may positively or negatively affect the economy, although it is usually the
latter. Externalities create situations where public policy or government intervention is
needed to detract resources from one area to address the cost or exposure of another.
Consider the example of an oil spill; instead of those funds going to support innovation,

25
public programs, or economic development, resources may be inefficiently put towards
fixing negative externalities.
What Is the Most Common Type of Externality?
Most externalities are negative, as the production process often entails by products, waste,
and other consequential outcomes that do not have further benefits. This may be pollution,
garbage, or negative implications for worker health. Many externalities are also related to
the environment, as the mechanical nature of manufacturing and product distribution has
many detrimental impacts on the environment.
How Can You Identify an Externality?
Companies must be mindful of their entire production process when assessing production
externalities. This includes not only implications of the final product but residual impacts of
by products, disposal of items not used, and how antiquated equipment is handled. This also
includes projecting outcomes of items yet to occur, such as waste yet to be properly disposed
of.
Consumers can identify consumption externalities by being mindful of the inputs and
outputs that go beyond what they are attempting to achieve. Consider an example of an
individual consuming alcohol. A consumer must be mindful that excessive drinking may
lead to noise pollution, an unsafe environment, or adverse health effects.
How Do Economists Measure Externalities?
Economists use two measures to evaluate an externality. First, economists use a cost-of-
damages approach to evaluate what the expense would be to rectify the externality. As we
may be seeing with greenhouse gas emissions, some externalities may extend beyond the
point of repair.
Another method of measuring externalities is the cost of control method. Instead of fixing
the externality, economists measure what pre emptive and preventative steps can be taken to
stop the externality from occurring. Similar to how an actuary assesses a financial value to
an event, economists may assign multiple financial measurements to an externality.
The Bottom Line
An externality is a by product of a primary process. This side effect may be good or bad and
may be caused by a production process or consumption process. Many externalities relate to
the environment due to the nature of company and individual actions, though there are many

26
ways governments, companies, and people can take responsibility to both prevent and rectify
externalities.
Public Policy
Public policy generally consists of the set of actions—plans, laws, and behaviours—adopted
by a government. Concern with the new governance draws attention to the extent to which
these actions are often performed now by agents of the state rather than directly by the state.
A vast number of studies offer detailed accounts of the impact of the new public
management and the rise of the new governance within particular policy sectors, such as
health care, social welfare, policing, and public security. However, policy analysis often
includes a prescriptive dimension as well as a descriptive one. Students of public policy
attempt to devise solutions to policy problems as well as to study governmental responses to
them. Of course, their solutions are sometimes specific proposals aimed at a particular policy
problem. At other times, however, they concern themselves with the general question of how
the state should seek to implement its policies.
The rise of the new governance raises a question: How should the state try to implement its
policies, given the proliferation of markets and networks within the public sector? Answers to
this question typically seek to balance concerns over efficiency with ones over ethics. To
some extent, the leading types of answers reflect the leading theories of governance.
Rational choice theory tends to promote market solutions; its exponents typically want to
reduce the role of the state in implementing policies. Institutionalism tends to concentrate on
strategies by which the state can manage and promote particular types of organizations; its
exponents typically offer advice about how the state can realize its policy agenda within a
largely given institutional setting. Interpretive theory tends to promote dialogic and
deliberative approaches to public policy; its exponents typically want to facilitate the flow of
meanings and perhaps thereby the emergence of a consensus.
Planning and regulating
The stereotype of “old governance” is of a bureaucratic state trying to impose its plan on
society. Formal strategic planning did indeed play a prominent role in much state activity in
the latter 20th century. However, there remains widespread recognition that strategic
planning is an integral feature of government. Plans help to establish the goals and visions of
the state and its agencies, and they facilitate the concentration of resources in areas where
they are thought to be most likely to improve an organization’s efficiency in relation to its
dominant goals. Of course, plans are not set in stone. Rather, they are made on the basis of

27
assumptions that might prove inaccurate, and of visions that might change, in ways that
require the plan to be modified.
Although planning remains an integral feature of government, there has been much debate
over how the state should implement its plans and policies. Neoliberals want the state to
concentrate on steering, not rowing, and they have sometimes argued that a focus on steering
would enable the state to plan more effectively: when state actors step back from the delivery
of policies, they have more time to consider the big picture. Neoliberalism represents less a
repudiation of planning than an attempt to contract out or otherwise devolve the delivery of
policies to non-state actors. Typically, its advocates suggested that devolving service delivery
would do much to foster a more entrepreneurial ethos within public services; it was said that
the new public management would free managers to manage. Nonetheless, if some
neoliberals appear to think that market mechanisms can ensure that non-state actors will do as
the state or citizens wish (or should wish), others recognize that the state still has to structure
and oversee the policy process. The state still has to set the goals for other actors, and it has
to audit and regulate these actors in relation to these goals. Even as the state forsook direct
intervention, so it expanded arms-length attempts to control, coordinate, and regulate other
organizations. The new governance included expanded regimes of regulation, with a growing
number of agencies, commissions, and special courts enforcing rules to protect competition
and social protection.
Managing networks
Social scientists often conclude that the withdrawal of the state from service delivery led to a
proliferation of networks and regulatory institutions. The spread of networks appears to have
further undermined the ability of the state to control and coordinate the implementation of its
policies. Social scientists, notably institutionalists, thus argue that effective public policy now
depends on mechanisms for controlling and coordinating networks. There are several
different approaches to the management of policy networks. Some approaches attempt to
improve the ability of the state to direct the actions of networks by means of law,
administrative rules, or regulation. Others focus on the ability of the state to improve the
cooperative interactions between the organizations within networks; typically, they suggest
that the state can promote cooperation by altering the relevant incentive structures. Yet other
approaches concentrate on negotiating techniques by which the state might
promote incremental shifts in the dominant norms and cultures within networks.

28
The different strategies of network management can be seen as complementing one another.
In this view, the state should deploy different policy styles as appropriate in different settings.
Public-sector managers respond to citizen references and specific problems in concrete
settings. Generally, they have to bear in mind multiple objectives, including meeting quality
standards, promoting efficiency, remaining democratically accountable, and maintaining
public trust and legitimacy. Their responses to problems are typically pragmatic ones that aim
to satisfy all of these objectives rather than to maximize performance in relation to any one of
them.
Many approaches to network management reject the command-and-control strategies
associated with hierarchic bureaucracies. In this view, because the state now depends on
other organizations, it has to rely on negotiation and trust. Some social scientists thus suggest
that the new governance requires a new ethic of public service. The state should neither row
nor merely steer. It should act as a facilitator or an enabler. It should help foster partnerships
with and between public, voluntary, and private-sector groups. It should
encounter citizens not merely as voters or as consumers of public services but as active
participants within such groups and so policy networks. Instead of defining the goals of
public policy in advance, it might even allow the public interest to emerge
from dialogues within networks.
Dialogue and deliberation
Sociological institutionalism and interpretive theory highlight the ways in which meanings,
beliefs, cognitive symbols, and conceptual schemes have an impact upon the policy process.
Some of their advocates suggest that the state might try to manage public policy by means of
negotiation and other techniques designed to produce incremental shifts in the culture of
networks. Others are less focused on the state; they advocate dialogue and deliberation as
means to give greater control of the policy process to citizens. These latter advocate giving
greater control to citizens partly for democratic reasons and partly because doing so can
improve policy making and policy implementation. Some of them argue that the direct
involvement of citizens became both more important and more plausible as a result of the rise
of the new governance and the emergence of new information technologies.
Advocates of dialogue and deliberation argue that they facilitate social learning. In this view,
public problems are not technical issues to be resolved by experts. Rather, they are questions
about how a community wants to act or govern itself. Dialogue and deliberation better enable
citizens and administrators to resolve these questions as they appear in concrete issues of

29
policy. They enable a community to name and frame an issue and so to set an agenda. They
inform those involved about their respective concerns, preferences, and ideas for solutions.
They help to establish trust and, so, cooperative norms within a community. And perhaps
most important, they are said to help reveal common ground, even to generate a consensus
about the public good. Hence, they appear to pave the way for common action.
Critics point to various problems with dialogic and deliberative policy making. They argue
that it is unrealistic given the size of modern states, it ignores the role of expertise in making
policy decisions, it inevitably excludes groups or viewpoints, it is slow, and it cannot respond
to crises. Critics also suggest that some policy areas—such as national security—are
particularly inappropriate for direct citizen involvement. Despite such criticisms, citizen
involvement, even if only as voters, is surely a necessary requisite of good, democratic
governance.
Democratic governance
Questions about public policy are partly normative. Policy processes should ideally reflect
the values of the citizenry. Today these values are generally democratic ones. However,
the new governance raises specific problems for our democratic practices. Democracy is
usually associated with elected officials making policies, which public servants
then implement. The public servants are answerable to the elected politicians who, in turn,
are accountable to the voting public. However, the rise of markets and networks has disrupted
these lines of accountability. In the new governance, policies are being implemented and
even made by private-sector and voluntary-sector actors. There are often few lines of
accountability tying these actors back to elected officials, and those few are too long to be
effective. Besides, the complex webs of actors involved can make it almost impossible for the
principal to hold any one agent responsible for a particular policy. Similar problems arise for
democracy at the international level. States have created regulatory institutions to oversee
areas of domestic policy, and the officials from these institutions increasingly meet to set up
international norms, agreements, and policies governing domains such as the economy and
the environment.
There is no agreement about how to promote democracy in the new governance. To some
extent, the different proposals again reflect different theories of governance in general.
Rational choice theorists sometimes suggest markets are at least as effective as democratic
institutions at ensuring popular control over outcomes. Institutionalists are more likely to
concern themselves with formal and informal lines of the accountability needed to sustain

30
representative and responsible government. These institutional issues merge gradually into a
concern to promote diverse forums for dialogue—a concern that is common among
interpretive theorists.
“Good” governance
Concerns about democratic governance first arose in discussions of economic development.
Economists came to believe that the effectiveness of market reforms was dependent upon the
existence of appropriate political institutions. In some ways, then, the quality of governance
initially became a hot topic not because of normative democratic concerns but because it
impinged on economic efficiency, notably the effectiveness of aid to developing countries.
International agencies such as the International Monetary Fund (IMF) and the World
Bank increasingly made good governance one of the criteria on which they based aid and
loans. Other donors followed suit.
The concept of good governance was thus defined by institutional barriers to corruption and
by the requirements of a functioning market economy. It was defined as a legitimate state
with a democratic mandate, an efficient and open administration, and the use of competition
and markets in the public and private sectors. Various international agencies sought to specify
the characteristics of good governance so conceived. They wanted checks on executive
power, such as an effective legislature with territorial (and perhaps ethno-cultural)
representation. Likewise, they stressed the rule of law, with an independent judiciary, laws
based on impartiality and equity, and honest police. They included a competent public service
characterized by clear lines of accountability and by transparent and responsive decision
making. They wanted political systems to effectively promote a consensus, mediating the
various interests in societies. And they emphasized the importance of a strong civil
society characterized by freedom of association, freedom of speech, and the respect of civil
and political rights. Some international agencies, such as the World Bank, also associated
good governance with the new public management; they encouraged developing states to
reform their public sectors by privatizing public enterprises, promoting competitive markets,
reducing staffing, strengthening budgetary discipline, and making use of nongovernmental
organizations. Other organizations, such as the UN, place greater emphasis on social goals,
including inclusiveness, justice, and environmental protection.
Non-majoritarian institutions
It was perhaps ironic that international agencies and Western donors began to emphasize
good governance just as the proliferation of markets and networks posed questions about

31
their own democratic credentials. The new governance sits oddly beside the ideal of
representative and responsible government in accord with the will of the majority. It involves
private- and voluntary-sector actors in policy processes even though these actors are rarely
democratically accountable in as straightforward a way as are public-sector actors.
There are many responses to the tension between governance and democracy. These
responses vary from the suggestion that society might benefit from less democracy to
proposals to make networks and markets more accountable to elected officials and on to calls
for a radical transformation of democratic practices. The suggestion that less democracy
might prove beneficial generally comes from people indebted to rational choice theory. Their
argument contrasts democracy, which allows citizens to express their preference by voting
only once every few years and only by a simple “yes” or “no” for a whole slate of policies,
with the market, which allows consumers to express their preferences continuously, across a
range of intensities, and for individual items. In addition, they worry that democracy entails
certain political transaction costs that make it prone to incessant increases in public
expenditure. One problem is that the costs of any item of expenditure are thinly distributed
across a large population, which thus has little reason to oppose them, whereas the benefits
are often concentrated in a small population, which thus clamours for them. Hence, they
advocate non-majoritarian institutions as ways of protecting crucial policy areas, such as
banking and budgeting, from democracy.
Democratic visions
Many people are uncomfortable with the growing role of non-majoritarian (or undemocratic)
organizations in government. Often they associate the growing role of such organizations
with growing public disinterest in or distrust of government. Moreover, the democratic
legitimacy of new forms of governance has been questioned. Parts of this discussion have
sought to reconcile the new governance with democracy by rethinking the concept of
democratic legitimacy. Historically, this concept has privileged electoral accountability
together with a bureaucratic accountability in which the actions of unelected agents are
controlled, evaluated, sanctioned, and answered for by elected officials. The transformations
brought about by the new governance have led some to advocate expanding the concept of
democratic legitimacy to encompass efficacy, legal accountability, or social inclusion.
One possibility is that the legitimacy of organizations and their decisions might rest on their
effectiveness in providing public goods—a perspective that clearly resonates with the
arguments for the efficiency of markets and non-majoritarian institutions. Alternatively,

32
legitimacy can be ascribed to organizations that are created and regulated by democratic
states no matter how long and obscure the lines of delegation. In this view, democratic
legitimacy is maintained whenever elected assemblies set up independent organizations in
accord with rules that are monitored by independent bodies such as courts. Legitimacy is
maintained here because the independent organizations are legally accountable, and a
democratic government passed the relevant laws. Alternatively, the legitimacy of institutions
and decisions might rest on their being fair and inclusive. Proponents of this view often
emphasize the importance of a strong civil society in securing a form of accountability based
on public scrutiny. Voluntary groups, the media, and active citizens monitor institutions and
decisions to ensure that these are fair and inclusive. They thereby give or deny organizations
the credibility required to participate effectively in the debates, negotiations, and networks
that generate policy.
Discomfort with the democratic credentials of the new governance can also lead people to
search for new avenues of citizen participation or at least to try to enhance the older avenues
of participation. Here the democratic policy process can be divided into stages, such as those
of deliberation, decision, implementation, evaluation, and review. Typically, citizens already
have avenues of participation at several stages. Citizens often can participate, for instance, by
writing to newspapers, voting on ballot measures, and serving on advisory boards.
Nonetheless, because many stages of the policy process are increasingly outside of the direct
control of elected officials, there is a case for enhancing opportunities for participation even
if one does not believe in participatory democracy as a political ideal. Proposals for
enhancing participation include public hearings, town hall forums, referenda, deliberative
polls, citizen representatives on committees, various types of self-steering, and citizens’
juries. Advocates of more-participatory democracy are often acutely aware that different
citizens possess different resources for participating. Hence, they often attend carefully to
process issues about who participates in what ways and under what circumstances. So, for
example, they might advocate state support for underrepresented groups. Typically, their goal
here is to increase equality and social inclusion in relation to participation.
Conclusion
The term governance can be used at various levels of generality and within various
theoretical contexts. The diversity of uses exceeds any attempt to offer
a comprehensive account of governance by reference to a list of its properties.

33
The concept of the new governance refers, most prominently, to an institutional shift—at all
levels of government, from the local to the international—from bureaucracy to markets and
networks. Of course, it is important to remember that this shift is neither universal nor
uniform and that bureaucracy probably remains the prevalent institutional form. Nonetheless,
the shift from bureaucracy to markets and networks means that the central state often adopts a
less hands-on role. Its actors are less commonly found within various local and sectoral
bodies and more commonly found in quangos concerned to steer, coordinate, and regulate
such bodies.
The concept of governance conveys, most importantly, a more diverse view of authority and
its exercise. In the new governance, the neoliberal quest for a minimal state and the more
recent attempts to promote networks are attempts to increase the role of civil society in
practices of rule. Likewise, theories of governance generally suggest that patterns of rule
arise as contingent products of diverse actions and political struggles informed by the varied
beliefs of situated agents. Some of these theories even suggest that the notion of
a monolithic state in control of itself and civil society was always a myth. The myth obscured
the reality of diverse state practices that escaped the control of the centre because they arose
from the contingent beliefs and actions of diverse actors at the boundaries of the state and
civil society. In this view, the state always has to negotiate with others, policy always arises
from interactions within networks, the boundaries between the state and civil society are
always blurred, and transnational and international links and flows always disrupt national
borders.

xxx-----xxx-----xxx

34